As discussed in a PubCo post last week, a theory that is currently gaining purchase is that, whether as a result of say on pay or otherwise, the increased influence of proxy advisory firms has led to a kind of homogenization of executive pay packages based on standard metrics. This piece in the WSJ, by a former CFO, argues that these types of standardized formula pay programs are problematic and, because “the days of ‘I’ll scratch your back’ cronyism are long gone,” more board discretion is warranted. He even spots a trend in that direction.
The author contends that companies have been prodded by proxy advisory firms into adopting formulaic comp plans that rely on standardized measures such as total shareholder return (TSR) and financial metrics, such as revenue, earnings per share, return on capital or free cash flow. Although, he argues, these types of formulaic plans may offer the comfort of presumed objectivity, strict adherence to these metrics may not always make sense:
- These metrics are too often affected by events outside of management’s control, from factors such as Brexit to currency translation.
- They “may incentivize short-term thinking and undue risk-taking… often favoring actions that have immediate impact, such as share repurchases, over longer-term investments with less certain paybacks.
- They often undervalue qualitative factors (e.g. customer experience, employee relations or brand image).”
SideBar: There seems to be an endless variety of approaches advocated for structuring executive comp: using value-based performance metrics such as return on invested capital greater than the cost of that capital and economic profit (see this PubCo post); extending performance periods to five years (see this PubCo post); using short-term incentives (see this PubCo post); adopting as a metric economic profit, i.e. net operating profit minus a capital charge for invested capital (see this PubCo post); and even limiting executive comp to a fixed salary only, on the theory that the nature of a CEO’s work is unsuited to performance-based pay (see this PubCo post).
The author joins the crowd in bashing the use of total shareholder return (TSR) as a metric. Although TSR can reflect near-term financial results, qualitative factors and long-term projections, he believes that “it’s hard to design TSR formulas that sufficiently incentivize the actions that the board wants to reward for the following reasons:
- A formula based on absolute TSR will be dominated by moves in the overall stock market. Relative performance is a better way to measure management’s value added.
- If TSR is compared with a market index (e.g. S&P 500), it’s hard to distinguish how much of the relative performance is due to the company’s industry conditions, strategic actions (e.g. divestitures or share repurchases), or execution of business strategies.
- If TSR is compared with industry competitors, it brings more focus to management’s execution of business strategies, but it makes relative performance dependent on the peer group’s composition and creates the possibility that compensation may be increasing when the company’s financial results and stock price are declining.
- TSR formulas can be distorted by market fluctuations (e.g. actions by shareholder activists or [other] anomalies….).”
SideBar: The author is not alone in criticizing the “tyranny of TSR” as a performance metric. As discussed in this PubCo post, a study by Cornell University and Pearl Meyer, an executive compensation consultant, showed no real correlation to improvements in company performance, reports the WSJ. In the study, over 48% of S&P 500 companies used TSR as a performance metric in 2013, up from less than 17% in 2004. However, according to one of the study’s co-authors, “[t]here was not any conclusive evidence that the positive relationship was there.” Similarly, this PubCo post discusses a report that argues that tying compensation to share price appreciation through TSR is deeply misguided because factors that affect share price, such as “fund flows, central bank policies, macroeconomics, geo-political risks and regulatory changes are all beyond the control of executive management.” Even “relative TSR, as conventionally calculated, also assumes re-investment of all dividends, and hence, does not properly capture those situations where value is created by decreasing the level of capital invested in the business.”
Instead of relying solely on quantitative metrics, the author suggests that boards should be allowed “more latitude in evaluating their meaning. They can judge the degree of difficulty, taking into account exogenous events, the competitive environment and market anomalies. And they can consider qualitative factors, including accomplishments and setbacks that aren’t captured in the metrics.” If using discretion seems to evoke the days when executive comp decisions were censured as products of “cozy relationships and arbitrary decisions,” the author doesn’t deny it. Rather, he contends that the pendulum veered too far toward objective measures and that a reasonable swing back now would be justified because governance practices have now “dramatically improved.” For “the most part,” he opines, “the days of ‘I’ll scratch your back’ cronyism are long gone. Today’s directors are both highly-engaged and scrupulously-independent; they can be trusted to do the right thing. Moreover, the Dodd-Frank reforms which led to the SEC’s requirements for ‘say-on-pay’ advisory votes give shareholders a further check and balance against sweetheart deals.” As a result, the author urges that we “heartily embrace” an “emerging trend toward less adherence to a strictly formulaic approach and more room for boards to make discretionary judgments, which used to be more the norm.”
SideBar: Of course, the notion that “cronyism” is largely over would certainly be the subject of debate from some quarters, as would the advisability of an invitation to increase the use of discretion in executive pay. And it’s fairly well known that shareholders overwhelmingly approve executive pay packages, even though studies have shown that most investors think CEOs at S&P 500 companies were paid “too much.” (See this PubCo post.) While not necessarily the type of discretion that the author envisions, some “latitude” has increasingly seeped into the mix indirectly through the use of non-GAAP financial measures as comp metrics. The WSJ reports that, according to Audit Analytics, the term “non-GAAP” appeared in 58% of proxies for companies in the S&P 500 in 2016 compared to only 27% five years ago. And often, the article reports, the reference to “non-GAAP” meant that the CEO was awarded higher pay than would have resulted had the reference been instead to “GAAP.” Many of those non-GAAP adjustments may be perfectly appropriate, the article argues, for example, where a non-GAAP adjustment reflects a natural disaster or other event outside the company’s control. However, the WSJ asserts, “other items that often get excluded in pro forma results, such as layoff-related charges, do seem like a reflection of management’s performance. And boards have too often shown a willingness to set awfully low bars for executives to clear. That, though, can disadvantage shareholders and wreck the idea of pay for performance.” The article reports that about 12 of the 30 DJIA component companies had non-GAAP earnings that were “well in excess” of GAAP earnings and based their executive bonuses on those non-GAAP earnings. And some companies have used non-GAAP measures other than earnings, such as economic profits, to set bonus amounts. (See this PubCo post.)